The Next Oil Price Collapse

By :    Michael Lynch  

There is significant optimism about oil prices for next year given the return of inventories to something approaching “normal” levels, and a high degree of compliance among oil producers who have agreed to cut production. Strong economic growth should produce robust demand next year, and there is a relatively strong consensus that the market will be bullish for oil prices, with some talking about a $70 or $80 target for Brent. Compared to the swings of the last decade, a $10 or even $20 increase seems like a pittance, but would actually put $100 billion to $200 billion into the pockets of OPEC countries, and add tens of billions to the oil industry’s revenues.

 And numerous events could cause prices to move upward, including civil unrest in Venezuela or Libya, increased attacks on Nigerian producing facilities, disputes between the governments in Baghdad and Kurdistan, the re-imposition of sanctions on Iran, and technical problems at any number of large facilities around the world.

But market tightness seems unlikely to cause a sharp increase in prices, since a number of producers would presumably take that opportunity to raise production. But one assumes that the Southwestern U.S. has seen new sightings of that 1980s bumper sticker, “God grant me one more boom and I promise not to screw it up,” a sticker that’s gotten more use than “Clinton for President.” Because it’s boom and bust, not boom and boom or boom and plateau, a basic fact that the industry and investors seem to forget.

How could it happen again? The four major modern price collapses —1986, 1998, 2008, and 2014— have each had a different cause, and provide some idea of what might cause another collapse next year. The first was the result of a market collapse — OPEC production fell by half from 1980 to 1985 — due to excessively high prices. In 1998, the market was not under such strong pressure, but most OPEC nations were exceeding their quotas, led by Venezuela, which proclaimed its defiance to the organization. A combination of short-term economic weakness leading to higher inventories and a determination by Saudi Arabia to rein in the errant producers led to the lowest prices in many years.

The crash in 2008 was directly tied to bubble in oil prices that occurred that year, but combined with financial contagion — equities collapsed signaling a recession and sending investors into cash. The most recent price collapse was somewhat like 1986, in that OPEC’s market share appeared to be under threat, though the danger was in the future, not the past.

Thus the likely causes of a new oil price ‘collapse’ include financial contagion, conflict among OPEC and non-OPEC producers over compliance to output reductions, and pressure on OPEC’s market share.

Financial Contagion

The 2008 oil price crash was somewhat unique, in that it represented both the collapse of a bubble that sent prices to nearly $150 and the impact of financial contagion. At the time, of course, numerous pundits insisted that the market was not in a bubble, with famed oilman T. Boone Pickens saying, “Eighty-five million barrels of oil a day is all the world can produce, and the demand is 87 million ... It’s just that simple.” He predicted in August of that year, after prices had begun declining, "In two or three years, we're going to be at $200 a barrel—could be $300 a barrel for oil.”